Your federal tax privilege checklist

Editor: Roby B. Sawyers, CPA, Ph.D.

During a tax examination, the IRS may request documents and other information, such as testimony. Indeed, Sec. 7602(a) provides broad authority to the IRS in requesting information:

(a) Authority to summon, etc.

For the purpose of ascertaining the correctness of any return, making a return where none has been made, determining the liability of any person for any internal revenue tax or the liability at law or in equity of any transferee or fiduciary of any person in respect of any internal revenue tax, or collecting any such liability, the Secretary is authorized —

(1) To examine any books, paper, records, or other data which may be relevant or material to such inquiry;

(2) To summon the person liable for tax or required to perform the act, or any officer or employee of such person, or any person having possession, custody, or care of books of account containing entries relating to the business of the person liable for tax or required to perform the act, or any other person the Secretary may deem proper, to appear before the Secretary at a time and place named in the summons and to produce such books, papers, records, or other data, and to give such testimony, under oath, as may be relevant or material to such inquiry; and

(3) To take such testimony of the person concerned, under oath, as may be relevant or material to such inquiry.

The IRS's authority, however, is not unlimited. Before a court will enforce a summons for information, for example, the IRS must prove that the information sought (1) is relevant; (2) is sought for a legitimate purpose; (3) is not already in the possession of the government; and (4) is being sought after the IRS has followed required administrative steps (Powell, 379 U.S. 48 (1964)).

While a request for information may meet the broad standards of Powell, the IRS may not obtain information that is protected from disclosure under an evidentiary privilege. This column reviews those privileges and related doctrines that are most applicable during an IRS examination.

There are several specific privileges that may protect the disclosure of confidential communications. Rule 501 of the Federal Rules of Evidence, for example, refers to the following privileges: required reports, attorney-client, psychotherapist-patient, spousal, communications to clergy, political vote, trade secrets, state secrets, and informer identity. Irrespective of which privilege may apply, in cases where it does, it allows the person claiming the privilege to prevent disclosure of the communication or other evidence about the subject to which the communication relates. Indeed, rules of privilege are generally rules of evidence — where privilege applies, it can work to properly prevent the disclosure or introduction of testimony or documents.

Waiver of privilege

The disclosure of confidential information to a third party by the privilege holder can constitute a waiver of the privilege. Such disclosure can be voluntary or inadvertent; it can be by the client (holder of the privilege) or by the adviser (attorney). In the case of a waiver, the confidential communication may then lose its privilege.

The attorney-client privilege protects confidential communications between an attorney and client for the purposes of the client's obtaining legal advice. In a tax matter, this can protect communications between the attorney and the client dealing with the provision of tax advice. The attorney-client privilege in tax matters, however, has its limitations. Where advice is sought during tax return preparation, i.e., the advice is related to the preparation of tax returns that will be filed with a tax authority, privilege generally will not apply. In such cases, it is generally viewed that there is a waiver of the privilege in that the nature of the advice will be revealed on a tax return filed with a third-party tax authority.

In some instances, communication that may otherwise be covered by attorney-client privilege will lose its protection. If a third party, such as an accountant, is privy to the communication, that will also generally be considered a waiver of the privilege.

Where confidential communication is revealed to a third party, however, there may be grounds in which privilege may be upheld. In the case of Kovel, 296 F.2d 918 (2d Cir. 1961), privilege was upheld (i.e., not waived) where an accountant, who was employed by a law firm that specialized in tax, was present while the client communicated his facts to his attorney. In Kovel, because the communication was made in confidence and in the scope of the client's seeking legal advice, the presence of the attorney's employee accountant did not cause a waiver.

In cases where an attorney has been retained to assist with a tax matter, an accountant may be retained to assist the attorney with the legal engagement. Under the principles of Kovel, any of the work product of the accountant should be subject to the attorney-client privilege protection. To formalize those arrangements, a special-purpose engagement letter, called a Kovel letter, is often used to memorialize the arrangement between the attorney, the accountant, and the taxpayer client. The use of a Kovel letter documents the arrangement and the parties' intent that any communication be subject to the attorney-client privilege.

While the use of a Kovel letter exhibits the parties' intent to preserve the attorney-client privilege, it is not guaranteed that privilege will be respected by the IRS or upheld by a court. Practitioners and taxpayers also must keep in mind that, where the attorney-client privilege is respected, it can still be waived by disclosing the confidential communication to a third party outside the Kovel arrangement. In addition, for advice related to tax return preparation, as discussed above, privilege generally will not apply.

Throughout the United States, there is generally no formal accountant-client privilege. States have varying laws respecting the rules of confidentiality between accountant and client, and the AICPA has rules requiring confidentiality between accountant and client. Without a formal general privilege rule, however, it may be more difficult for a client to assert that communications or documents are protected from disclosure.

The absence of a formal accountant-client privilege was one of the catalysts to enactment in 1998 of the federally authorized tax practitioner privilege codified in Sec. 7525. Congress intended that the "provision extends the attorney-client privilege of confidentiality to tax advice that is furnished to a client-taxpayer (or potential client-taxpayer) by any individual who is authorized under Federal law to practice before the IRS" under Treasury Circular 230, Regulations Governing Practice Before the Internal Revenue Service (31 C.F.R. Part 10). This includes attorneys, CPAs, enrolled agents, and enrolled actuaries (Joint Committee on Taxation, General Explanation of Tax Legislation Enacted in 1998 (JCS-6-98), p. 87 (Nov. 24, 1998)). The federally authorized tax practitioner privilege extends the attorney-client privilege to consultations with other federally authorized tax practitioners in federal tax matters — with limitations.

The federally authorized tax practitioner privilege may only be asserted in civil (noncriminal) tax proceedings before the IRS or a tax proceeding in federal court brought by or against the United States. In criminal cases, where an attorney is consulted, the attorney-client privilege generally would apply.

The limitation also prevents the privilege from being asserted before any regulatory body other than the IRS. For example, in matters before the SEC, the federally authorized tax practitioner privilege does not apply.

The federally authorized tax practitioner privilege also does not apply to any communication between a federally authorized tax practitioner and any person, director, officer, employee, agent, or representative of the person, or any other person holding a capital or profits interest in connection with the promotion of the direct or indirect participation in any tax shelter as defined in Sec. 6662(d)(2)(C)(ii) (Sec. 7525(b)).

Similar to the attorney-client privilege, the privilege under Sec. 7525 can be waived when a taxpayer or federally authorized tax practitioner discloses to a third party confidential communications otherwise protected under the privilege.

Related to the rules of privilege, the work product doctrine is not an evidentiary rule but rather a rule of discovery. Codified in Rule 26(b)(3) of the Federal Rules of Civil Procedure, the work product doctrine protects one party in litigation from being required to turn over to the other party materials prepared "in anticipation of litigation." This generally refers to materials that were prepared when litigation was on the horizon, i.e., when litigation was in sight.

The work product doctrine is both broader and narrower than the attorney-client privilege. It is broader in that it includes communications and materials prepared by individuals other than an attorney. For example, memoranda, projections, or other documents prepared by an accountant may be protected from turning over to the other party — if the materials were prepared in anticipation of litigation. Indeed, to the extent documents were prepared in the ordinary course of a taxpayer's business and not in anticipation of litigation, the documents generally would not enjoy work product protection.

Work product protection can, however, also be narrower than the attorney-client privilege. First, the doctrine protects only communications and documents prepared "in anticipation of litigation." While there are several approaches to defining when a document was prepared in anticipation of litigation in federal case law, each approach requires that the document has been prepared with an eye toward litigation. Some courts ask whether the document was prepared "because of" the prospect of litigation. Other courts look to the "primary purpose" the document was created. Courts also sometimes use a "function of the document test," asking whether the adverse party is requesting the document to understand the other party's litigating position.

For documents that contain material that was prepared both in anticipation of litigation and material that was not so prepared, the protected information can be redacted when turning over the document.

The work product doctrine also can be pierced by the adverse party's showing of substantial need and that, without an undue hardship, it cannot obtain the information by other means (Fed. R. Civ. P. 26(b)(3)(A)). The "mental impressions, conclusions, opinions, or legal theories of a party's attorney or other representative concerning the litigation" generally will not be discoverable by the adverse party (Fed. R. Civ. P. 26(b)(3)(B)).

As discussed above, information and communication made solely for the preparation of tax returns generally is not protected from disclosure. Other communication ancillary to the preparation of tax returns may be subject to privilege, such as communications to discuss possible tax positions or other planning advice. In evaluating the application of the several doctrines of privilege and work product, consideration of the purpose of the communication is important in assessing whether and to what extent privilege and work product may apply.

Once a practitioner and client identify that there may come a time when a claim of privilege or work product may be asserted for some communication or document, some steps can be taken to bolster the client's protection. For documents that may be subject to privilege, such as attorney-client or the federally authorized tax practitioner privilege, a notation should be made in the file and on the documents once the potential for a privilege claim is identified. Where privileged communication is at issue, a note to the file memorializing the conversation and fact of the confidential communication should be considered. Where documents are created that may be subject to a privilege or work product claim, a notation on the document that it is intended to be a confidential communication between practitioner and client, while not conclusive as to privilege and work product, can certainly show the intent that it should be protected.

Privilege logs

In tax examination and litigation cases, taxpayers generally cannot make blanket claims of privilege; i.e., claims that a group of documents or communication are simply "privileged" or otherwise protected. Such blanket claims generally will be held insufficient to uphold claims of privilege.

To help identify documents and communication with more specificity so that claims of protection are deemed adequate, "privilege logs" are generally required. Rule 26(b)(5) of the Federal Rules of Civil Procedure, for example, which is a rule addressing discovery in federal cases, provides that when a party to litigation withholds information that would otherwise be discoverable, that party must "expressly make the claim" and "describe the nature of the documents, communications, or tangible things not produced or disclosed — and do so in a manner that, without revealing information itself privileged or protected, will enable other parties to assess the claim." The IRS also directs its staff to request a privilege log in cases where a privilege is raised in an exam or in response to a summons (see, e.g., Internal Revenue Manual §25.5.5.4.3 (12/18/15)).

In completing a privilege log, the kinds of information that should be included would be, for example, the type of document or communication being withheld, the author(s) of the document, whether and to what extent it may have been redacted, the date it was created, a high-level summary of the information (without revealing the confidential communication), and the grounds of protection from disclosure (e.g., attorney-client privilege, federally authorized tax practitioner privilege, or work product).

Tax practitioners serve their clients in a variety of ways. From tax return preparation, to transactional tax consulting, to tax planning, or some combination of each — practitioners must be aware of the various possible types of protection available to their taxpayer clients during the course of an examination or litigation matter.

As with most doctrines, however, there are limitations. If an adviser believes a client may benefit from the assertion of privilege for some advice or document, steps should be considered to ensure that the best argument can be made to preserve privilege or work product protection if and when the time comes to make such a claim. Moreover, in cases where there is uncertainty as to the application of the federally authorized tax practitioner privilege, or where a taxpayer is facing possible legal jeopardy, it may be appropriate to recommend that a taxpayer client retain an attorney.